June, 2007 Newsletter
Provided by Leimberg Information Services

New Question on Estate Tax Return Highlights Strategic Issues

The most recent revision of the federal estate tax return includes a question that was not present on previous versions. Bruce D. Steiner of the New York City law firm of Kleinberg, Kaplan, Wolff & Cohen, P.C. explains what the new question asks, and how it may affect gift and estate tax planning and reporting.

EXECUTIVE SUMMARY:

The estate tax return now asks about sales to grantor trusts. This may affect the choice between a GRAT and a sale to a grantor trust, and whether to disclose certain sales.

FACTS:

The federal estate tax return (Form 706) was revised in October 2006 for estates of persons dying on or after January 1, 2006.

Part 4, question 12c on page 3 of the return asks whether the decedent ever transferred or sold an interest in a partnership, limited liability company (LLC) or closely-held corporation to a trust in existence at the decedent's death that the decedent created or under which the decedent possessed any power, beneficial interest or trusteeship. If so, the return asks for "the EIN number to this transferred/sold item."

COMMENTS:

Two common estate planning techniques are the grantor retained annuity trust (GRAT) and the sale to an intentionally defective grantor trust (IDGT).

The advantages of the GRAT are that it is statutorily authorized, there need not be any taxable gift, and changes in values on audit affect the amount of the annuity payments but not the amount of the taxable gift. However, the grantor must survive for the term of the GRAT, and cannot allocate GST exemption until the term ends.

Among the advantages of the sale are that the interest rate is the applicable Federal rate (AFR), which is lower than the Section 7520 rate used for GRATs, and that the donor can allocate GST exemption at the inception of the trust.

There has been a difference of opinion as to whether to disclose a sale to an IDGT on the gift tax return. Some taxpayers disclose the sale so as to start the running of the gift tax statute of limitations. Absent disclosure, the Internal Revenue Service can audit the transaction at any time, and can assert gift tax, interest and penalties. Other taxpayers do not disclose the sale, so as to reduce the likelihood of an audit, as in Sharon Karmazin (a Tax Court case that was settled). Until now, absent disclosure on the gift tax return, there was a good chance that the Service would never have become aware of the transaction.

As a result of this new question on the estate tax return, assuming the trust remains in existence until the taxpayer's death, the Service will know about the transaction at that time.

This presents the taxpayer with the following choices:

Disclosure on the gift tax return. The taxpayer can disclose the sale on the gift tax return. This will start the running of the statute of limitations (generally three years). Disclosure on the gift tax return takes advantage of the fact that the percentage of gift tax returns that are audited is much lower than the percentage of estate tax returns that are audited.

Creating a GRAT. If the choice between the GRAT and the sale is a close one, the taxpayer might create a GRAT instead of selling assets to a grantor trust. As set forth above, in the case of a GRAT, if the values are changed on audit, the result is a change in the annuity payments rather than gift tax.

Terminating the trust. A disclosure of a sale on the estate tax return can be avoided by terminating the trust during the decedent's lifetime. However, if the trust assets are distributed to a beneficiary, this will cause the assets to be included in the recipient's estate, and will expose the assets to the recipient's potential creditors (including spouses).

Not disclosing the sale. Some taxpayers may continue to sell assets to grantor trusts without disclosing the sale on the gift tax return, concluding that it would be more difficult for the Internal Revenue Service to audit the transaction after the taxpayer's death many years later, especially if the partnership, LLC or closely-held corporation no longer exists.

CONCLUDING OBSERVATION:

Practitioners should reconsider the choice between the GRAT and the sale to a grantor trust in light of this new question on the estate tax return. If the choice remains the sale, practitioners should consider whether to disclose the sale on the gift tax return to start the running of the gift tax statute of limitations.

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